Recent Developments In The Market

  • Jul 05, 2019 BST
  • Team Kalkine
Recent Developments In The Market

What Investors need to derive from an Inverted Yield Curve in the US

The much famed and feared yield curve, which is the primary fear gauge for investors around the globe, has inverted in recent months in the United States. The slope of the curve is considered by many as a measure of confidence in the economy as the inversion has preceded every downturn since the end of the second world war, and so the recent inverted curve has signalled doubts about future growth. Though the US economy has officially entered the longest expansion in its history in the latest quarter, the Treasury yield curve has now been inverted for a full quarter, spooking investors sentiments and putting in doubt the sustainability of expansion.

The difference between the interest rate on long-term and short-term government debt is known as the slope of the Treasury yield curve. The price of a bond and the yield on it are inversely related, so if the demand for bond increases, its yield falls. Typically, in normal circumstances, investors demand higher yields on longer-dated securities as they seek compensation for unforeseen risks, gradual erosion due to inflation, or at worst, default by the government. In such a scenario, the yield curve slopes upwards, as it has for the most of its history. But when investors’ demand leads to a lower yield on 10-year Treasury bond than short-term securities, the yield curve inverses, acting as an effective messenger of recessions. When investors fear of a looming crisis or a recession, they start investing in the 10-year Treasury bond, which is considered as the safest asset in the world, thereby increasing its price and lowering the yields.

While the efficacy and underlying logic behind the concept might be disputed, experts have taken note of this and have urged investors to take caution. Even the curve-derived model of the New York Fed suggests that over the next 12 months, there is almost 30 per cent chance of a recession, predicting a recession later this year or in 2020. Several economic indicators present a gloomy picture and experts reckon that economic growth has slowed from the pace of last year. Estimates for growth in the second quarter of this year are at 2.5 per cent, in contrast to 4.2 per cent and 3.4 per cent in the second and third quarter of last year respectively. The positive impact of tax cuts by the Trump administration has started to wear off, and the economic growth is also most likely to feel the impact of the escalating trade war with China.

However, it is not a fool-proof leading indicator of an impending recession as many forces shape the yield curve. The policy rate in the US has been at its historic lows, even after some rate rise by the central bank, and that might have led to change in the information provided by the yield curve. The long terms securities have been influenced by the unconventional monetary policy undertaken by the central bank, known as quantitative easing. The Fed has on its balance sheet a significant proportion of outstanding long-term bonds, it owns on $2tn of Treasuries acquired through bond-buying programmes, and banks have been encouraged to keep more money in ultra-safe assets by post-crisis regulations. The combination of these two has artificially reduced the yields of the government bonds. Negative interest rates and easy money in other developed markets has meant ultra-low returns, further fuelling demand for US securities.

When the Fed changes its policy rate, Treasury bills, i.e. short-term securities, are affected the most as longer-dated securities are moved more by the market forces. In the past couple of years, the central bank has been increasing the interest rate, it raised interest rates nine times in the last three-plus years, which has driven yields of Treasury bill. Also, rather than issuing longer-term bonds, much of the widening budget deficit has been funded by issuing short-term bills by the US government, thereby increasing the supply of shorter-term bills. As inflation is still below the targeted rate, the premium for inflation seems to have reduced drastically. Moreover, consumer spending, which accounts for roughly 70 per cent of the US economy, is in great shape and wage growth is the best it has been since the great recession, helped by an unusually strong job market. This has reduced the chances of an imminent recession.

In the past, there have been instances when the yield curve inversion did not follow a recession, and the predicted power of the curve has been internationally mixed. Moreover, the average delay between the recession and the inverted curve is about five quarters, suggesting it can take a long time between an upside-down curve and an actual recession. However, the curve indicates that the monetary policy is too tight for the economy and has the power to force the central bank to cut rates again.

Stocks to Watch – SHI, WG, SXS and GLEN

SIG PLC

SIG PLC (SHI) is a leading European supplier of specialist building materials, including insulations and interiors, roofing and exteriors and air handling products, with operations across the UK, Ireland and Mainland Europe. In the half-year trading update, released on 5 July 2019, the company reported a 3.8 per cent decline in its like-for-like revenues over the period due to the deterioration in the level of construction activity in the country. The company said that trading conditions were challenging in many end markets but stuck to its full-year profit forecast on the back of a stronger second half.

Share Price Commentary

 Daily Chart as at July-05-19, before the market closed (Source: Thomson Reuters)

 On 5 July 2019, at the time of writing (before the market close, GMT 4:20 pm), SHI shares were trading at GBX 125.6, down by 5 per cent against the previous day closing price. Stock's 52 weeks High and Low is GBX 154/GBX 101.30. The company's stock beta was 1.28, reflecting more volatility as compared to the benchmark index. Total outstanding market capitalisation was around £782.92 million, with a dividend yield of 2.83 per cent.

John Wood Group PLC

John Wood Group PLC (WG) is an Aberdeen, Scotland-headquartered group which provides performance-driven project, engineering and technical services to its customers throughout the asset life cycle. The company is a global leader in the delivery of a myriad of services in energy, industry and the built environment, and provides a range of engineering, pipeline services, digital solutions, clean energy, production support, and repair services to the energy industry.

Recently, the market experts upgraded the stock from Hold to Buy with a price target of 590p, representing an upside of around 25 per cent over its previous day closing. Experts reckon that the company would experience a top-line growth backed by steady free cash flow, as integration costs would decrease, and cost synergies would be delivered. The exposure to the power and environmental/renewable markets augurs well for the company in the long run and the underperformance of the stock during the year provides an attractive buying opportunity.

Share Price Commentary

Daily Chart as at July-05-19, before the market closed (Source: Thomson Reuters)

 

On 5 July 2019, at the time of writing (before the market close, GMT 4:25 pm), WG shares were trading at GBX 488.1, up by 3 per cent against the previous day closing price. Stock's 52 weeks High and Low is GBX 801.2/GBX 379.74. The company's stock beta was 0.94, reflecting less volatility as compared to the benchmark index. Total outstanding market capitalisation was around £3.23 billion, with a dividend yield of 5.70 per cent.

Spectris PLC

Spectris PLC (SXS) is a leading supplier of productivity-enhancing instrumentation and controls which offers complete solutions combining hardware, software and related services for industrial applications. The company was downgraded from buy to underperform by the market experts with a target price of 2700p. Experts reckon that while the company had attractive countercyclical, end market deceleration could hit the company in the second half. Any delay in planned disposals would have a negative impact on the stock as it was already trading at a 20 per cent premium to peers on 2020 earnings.

Share Price Commentary

Daily Chart as at July-05-19, before the market closed (Source: Thomson Reuters)

On 5 July 2019, at the time of writing (before the market close, GMT 4:30 pm), SXS shares were trading at GBX 2,702, down by 6.4 per cent against the previous day closing price. Stock's 52 weeks High and Low is GBX 2,932.00/GBX 1,924.50. The company's stock beta was 0.92, reflecting less volatility as compared to the benchmark index. Total outstanding market capitalisation was around £3.35 billion, with a dividend yield of 2.11 per cent.

Glencore PLC

Glencore PLC (GLEN) is a Baar, Switzerland-based leading diversified natural resource group. The company operates around 150 assets, including agricultural facilities, oil production assets, mining and metallurgical sites. The group, using its sector knowledge and global supply base, is engaged in the business of production and distribution of metals and minerals, crude oil and oil products, coal and agricultural products.

Following the death of 43 informal miners on the site due to the collapse of a part of the open pit on June 27, the Congolese army has arrived at Glencore’s largest copper and cobalt mine, raising fears of violence and possible forced evictions of informal miners.

Share Price Commentary

 Daily Chart as at July-05-19, before the market closed (Source: Thomson Reuters)

 On 5 July 2019, at the time of writing (before the market close, GMT 4:35 pm), GLEN shares were trading at GBX 269.60, down by 1.1 per cent against the previous day closing price. Stock's 52 weeks High and Low is GBX 343.90/GBX 249.75. The company's stock beta was 2.04, reflecting more volatility as compared to the benchmark index. Total outstanding market capitalisation was around £37.26 billion, with a dividend yield of 5.62 per cent.

With Bank of England reducing the interest rates to a historic low level, the spotlight is back on diverse investment opportunities. 

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